The highs and lows of the economy affect people and markets in a variety of different ways. While some sectors of the economy are thriving, others may be sluggish. One economic indicator used to gauge the state of the American economy is the Consumer Price Index (CPI), which measures the rate of inflation in the U.S.

Inflation, which is defined as the rise in the average price level of all goods and services, can have a significant impact on the American economy and your financial affairs. Understanding the CPI, and the ways it measures inflation, can provide a strong foundation for understanding not only market and economic swings, but also the ways in which fiscal and monetary policies affect America’s finances, and your own. To begin, let’s take a look at the information used by the U.S. Bureau of Labor Statistics (BLS) to compile CPI data.

Determining the Market Basket

Each month, the BLS surveys prices for a “market basket” of goods and services in order to create an economic “snapshot” of the average consumer’s spending, which is quantified as the CPI. Actual expenditures are classified into more than 200 categories and eight major groups. These include the following, defined below by a sampling of items included within each group:

Other Goods and Services—tobacco, haircuts, personal services, and funeral expenses.

Because the CPI looks at expenditures in these fixed categories, this index is a valuable tool for comparing the current prices of goods and services to costs last month or one year ago.

Interpreting and Using the CPI

As a measure of inflation, the CPI has three main uses. First, the CPI often serves as an indication of the health of the economy and the effectiveness of government policy. To a certain extent, some inflation is the sign of a healthy economy; however, too much inflation, or no inflation at all, can be a sign of troubling economic times. In fact, one of the primary U.S. economic policy goals is to maintain an inflation rate ranging from 1% to 3% each year.

Constant fluctuations in the CPI will cause Congress and the Federal Reserve Board (the Fed) to take measures to control the amount of inflation and stimulate economic growth. As a result, business executives, labor leaders, and other private citizens may change their spending and saving patterns. For example, the Fed may attempt to curb rising inflation by raising short-term interest rates; this increase in the cost of borrowing money is likely to slow personal and business spending. Conversely, if the economy is not growing, the Fed may attempt to stimulate inflation by lowering short-term interest rates; in this case, lowering the cost of borrowing may trigger increased spending among businesses and individuals.

As a second use, the CPI helps determine the “real” value of a dollar over time by removing the effects of inflation. As prices increase, the purchasing power of a dollar decreases; in other words, more dollars are needed to purchase the same amount of goods and services. Comparing inflation-free wages and prices also allows economists to determine the actual earning and spending patterns of the American consumer, what percentages of money are being saved or spent in certain areas.

Lastly, the CPI is used as a means of adjusting salaries and government benefits to account for price changes. For example, as a result of collective bargaining agreements, wages of over 2 million workers increase according to the amount of change in the CPI. The CPI is also used to determine the benefits of almost 80 million people covered under government programs, including Social Security beneficiaries, military and Federal Civil Service retirees and survivors, and food stamp recipients. In addition, changes in CPI can be seen in the price of school lunches, as well as through rents, royalties, alimony payments, and child support payments as determined by private firms and individuals. Finally, the CPI has been used to adjust the Federal income tax structure to prevent increases in taxes caused solely by inflation.

For More Information

Inflation can have a serious impact on the American economy as it affects both government policy and the spending and saving patterns of businesses and individuals. Understanding and following changes in the CPI can help you know how the value of the dollar changes and estimate how inflation may affect your future plans. The U.S. Department of Labor (DOL) publishes current information on the CPI each month through the BLS. For more information, visit their website at www.bls.gov/cpi.